THE EURO AT TEN
ACHIEVEMENTS AND CHALLENGESPaul De Grauwe
University of Leuven

Keynote Lecture to be presented at 7th International Symposium, "The EU and Japanin the World" organized by the EU Institute in Japan on September 20th, 2008 in
Kobe, Japan.

Introduction
In this lecture I discuss the achievements and the challenges of the Eurozone. I
concentrate on the following issues. First, I analyze the record

with respect toinflation (sections 1 and 2). Second, I discuss the degree of price transparency in the
eurozone. Next I analyze the extent to which monetary union has promoted faster
economic growth. Fourth, I study the challenges that arise from the increasing
divergences of wages and prices within the Eurozone. I conclude with a discussion of
the governance of the eurozone and the political issues to which this leads.

1. Low inflation despite lack of monetary control
There can be little doubt that despite the acceleration of inflation during the last year
(2008) the inflation recordin the Eurozone has been outstanding as

figure 1

illustrates. True other industrialized countries have experienced similar successes. Yet
it remains an achievement for a new central bank, the ECB, to have established astrong low inflation reputation in such a short time span.
Figure 1: Inflation in the Euroarea

The surprising aspect of this development is that when it started, the ECB made it
clear that it wanted to achieve price stability by controlling the money stock (M3). In
this it was very much influenced by the monetarist dictum from Milton Friedmansaying that “inflation is always and everywhere a monetary phenomenon”. Thus in2

order to control inflation it was imperative to control the growth rate of the moneystock. This was the so-called first pillar in the monetary policy strategy that the ECB
set out right from the start of its operations (see ECB, Monthly Report, 1998). Using
the quantity theory the ECB-strategist computed the growth rate of M3 that wascompatible with an inflation target of 2%. This turned out to be 4.5% (given theassumption of long run real growth rate of 2% and a declining velocity of 0.5% per
year. Failure to keep the growth rate of M3 below 4.5% would inevitably lead to andinflation rate exceeding 2%.
How successful was this monetarist strategy. Sometimes a picture is worth one
thousand words. I show the picture in figure 2. I observe that apart from a very brief
period in 2000-01 M3 growth has permanently exceeded the reference value of 4.5%
and by far. The average yearly growth rate of M3 was 7.2% while inflation amounted
to 2.1% a year (see table 1). Thus it appears that the ECB monetary strategy which
consisted in keeping inflation low by controlling the growth rate of the money stock
failed dismally. The troubleshooter was velocity which declined on average by morethan 3% per year.
Figure 2

Source: European Central Bank, Monthly Bulletin3

Table 1: average yearly growth rates in the eurozone (1999-2007)
Mean growth rate M3:
7.2%
Mean inflation rate:
2.1%
Mean growth rate output:
2.0%
Velocity growth-3.1%
Source; ECB, Monthly Bulletin
What do we learn from this? First, the ECB completely failed in its announced
strategy to control inflation via monetary control. Second, it tells us much about thesignaling power of money growth in the Eurozone. And this is that M3 has had almost
no power in predicting future inflation in the Eurozone since 1999.
The question that arises next is why money growth has no information value for
future inflation. The answer is that in a low inflation environment the noise to signal
ratio of money growth is very high, i.e. most of the variability of money stocknumbers is noise and is unrelated to inflationary dynamics. Most of the noise comesfrom large portfolio effects and financial innovation. For example, the spectacularincrease in M3 observed after 2005 is the result of a massive expansion of the banks’balance sheets. This did not really increase liquidity (in the sense of means of
payments in the system). In order to understand why this is so we have to go back tothe basics of money and liquidity.
Banks create liquidity because they borrow short and lend long. In so doing, they
become less liquid themselves. This creates the possibility for others (the non-banking
sector) to become more liquid. But if banks were to add assets and liabilities of thesame maturities to their balance sheets, there would be no liquidity creation. Thus, it
is not sufficient to look at the growth rate of the banks’ liabilities to find out how
large liquidity creation has been. Since M3 consists mainly of banks’ liabilities, a 10
per cent increase in M3 may tell us nothing about liquidity creation.
In the past, when banks exerted their traditional roles of borrowing short and lending
long, the trends in the banks’ liabilities gave us a reliable picture of liquidity creation.
Financial innovations have changed the banking landscape, though.
First, many banks have restructured their assets. An important feature of thisrestructuring is that they have transformed relatively illiquid assets, such asmortgages, into asset-backed securities that can easily be traded and are thus more
liquid. By becoming more liquid themselves, banks create less liquidity.

4

Second, banks did the opposite on the liabilities side. They increasingly issued debt
securities at the expense of traditional deposits. As a result, the maturity structure of
the banks’ liabilities lengthened.
The upshot of these two trends is that banks borrow less short and invest less long.
Thus the spectacular increase in M3 may not at all be a signal of too much liquidity
creation. It may reflect the new activities of banks, which have been issuing longermaturity liabilities backed by shorter-maturity assets. Banks are now less in thebusiness of liquidity creation than they used to.
If this interpretation is correct, the ECB should not worry that the strong increase in
M3 is a signal of inflation to come. It only reflects the expanding business of banks,
which adds little to liquidity.
This conclusion may surprise. Is the world not drowning in a pool of liquidity? Yes,
but this has happened outside the traditional banks. Other institutions, hedge funds,
investment banks and special conduits in which banks have parked their illiquid assets
so as to circumvent regulations, have been responsible for liquidity creation recently.
They have done this in ways mirroring the changes observed in the banking sector.
Much of what these institutions and special conduits do is searching for “alpha”, ie
investment opportunities in unexplored niches. These are typically very illiquid
investments. In contrast, the liabilities of these institutions have a more liquidcharacter. As a result, they have become an important source of liquidity creation in
the world which occurs outside the balance sheets of the traditional banks.
Should the ECB worry about these developments? Yes and no. Yes, because it issystematically watching the wrong indicator (M3) of the trends in liquidity. As aresult, it gets the wrong signals about future inflation most of the time.
No, because the liquidity creation by the non-bank financial institutions does notincrease the price of the things we buy in the grocery stores. Thus, there is no need for
an inflation-targeting central bank to monitor what these institutions are doing.
There is a snag, though. When these institutions create liquidity, this is used to buy
assets. Thus, hedge funds, investment banks and special off-balance sheet conduits ofthe banks create inflation not in the grocery stores but in asset markets. A central bankthat cares about more than just prices in the stores may want to worry about thesedevelopments, because asset inflation can lead to bubbles and crashes.
5

Asset bubbles create optimism and euphoria, stimulating economic activity. The
crashes that follow can lead to pessimism and downturns in economic activity. Thus,a central bank that, besides inflation, also cares about economic stability may want tomonitor the activities of these non-bank financial institutions creating liquidity. Thereis an additional reason why the central bank should care. This is that a large part ofthe sort-term liabilities of these non-banks are in fact short-term credit provided by
the traditional banks. Thus when the non-bank financial institutions get into trouble
the traditional banks also do. Since the central bank is the lender of last resort for thebanks it will be affected by what happens with the non-bank financial institutions.
I conclude that using M3 as an indicator of future inflation is a bad idea. Using it as asignal of emerging bubbles in the asset markets is a good idea provided it is seconded
by other indicators such as total credit and asset prices. In this way the ECB could
develop a two pillar approach. The first pillar would be based on inflation targeting as
it is now practiced in many central banks. The second pillar would consist of amonitoring system of asset inflation, signalling to the ECB of incipient bubbles in
asset markets. This signal may then also be used to guide interest rate policies

2.The introduction of the euro and perceived price increases.
A major surprise about the introduction of the euro is its unpopularity in a number of
eurozone countries. Especially in Italy, but also in Germany and

Greece, theintroduction of the euro is associated with massive price increases. The ECB has
generally denied the existence of the phenomenon. There is evidence, however, that at
the time of the introduction of euro banknotes prices of goods and services that arebought frequently have increased significantly. I show some evidence in table 2.
Table 2
Table 1: Price increases of food products (from Nov 2001 to Nov 2002)
Breakfast (bread, snacks)
Pasta, bread, rice
Beverages
Meat, eggs and fresh fish
Cold cuts
Canned foodFruit and vegetables
Frozen food

23,3%
20,1%
32,9%
22,1%
27,5%
30,9%
50,8%
23,6%

Total

29,2%

Source: Italian Consumer Organization

6

Thus it appears that a number of products that are bought almost daily and for which
the price elasticity is generally low, the introduction of the euro has been used to raise
prices. The mechanism that could have triggered this is the following. Since theseproducts have a low price elasticity there is a potential for the sellers to exploit this.
However, these products are typically sold in highly competitive markets. As a result,
one seller can typically not expoit this profit opportunity without losing business. The
introdiuction of the euro created a window of opportunity whereby the sellers could
all raise their prices together.
All this has left a legacy of unpopularity of the euro, and a perception of highinflation. It is remarkable that since 2002 the perception of inflation in the eurozone
has systematically been higher than the official inflation as shown in figure 3
Figure 3

3. The promise of price transparency
The introduction of the euro, we were told, would lead to more price transparency, i.e.
consumers who now can see prices in the same currency unit would be better able to
make price comparisons, and to shop around. This in turn would increase competition.
In the end this would benefit all consumers who will face the same lower prices. How
much of this price transparency promise came out? Not much ascan be seen fromfigure 4. This shows the mean standard deviation of prices of a sample of 173

7

identical products across the Eurozone from 1990 to 2005. The study was performedby Wolszczak-Derlacz(2006). The study finds no evidence for price convergence inthe Eurozone. The remarkable observation is that price convergence occurred prior to1999 (mostly in the early 1990s) 1. Since the start of the Eurozone, price convergencehas stopped. 2 This phenomenon has also been observed by the European Commission(see European Commission (2004a)).
Figure 4 Evolution of price dispersion in the Eurozone, 1990– 2005
0,45

mean standard deviation

0,4

0,35

0,3

0,25
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Source: Wolszczak-Derlacz (2006).
Why does the introduction of the euro appear to be a weak force in bringing about
price convergence? The price differentials for retail products are likely to be the resultof inefficiencies at the retail level, where transaction costs are high. With or without
the euro it remains very costly for individual consumers living in, say, Paris to make atrip to Berlin so as to profit from a price advantage for some (not all) groceries. Sucharbitrage remains prohibitive in the Eurozone. But why then do we observe almost no
price differentials for supermarket products within the same countries? The answer isthat the retail business is still very much segmented nationally. In most countries a
few supermarket chains dominate the whole market. They conduct national

1

This is also found by Engel and Rogers(2004).

2

The slight increase in dispersion observed after 1999 is too small to be statisticallysignificant.

8commercial and advertising campaigns, setting prices for the whole national market.
Part of the reason is that most of these supermarket chains are still very much national
companies. The other part has to do with different regulations, customs, languages,
and cultures. It is doubtful that the euro will overcome all this very soon.
4. The promise of high growth“One market, one money”, the famous report issued by the European Commission in
the early 1990s, made an analysis of the economic growth effects of a monetary
union. Using insights from the so-called new growth theory it formulated a very
optimistic conclusion about the future growth that would be possible in the monetary
union. How much of this promise has come through? Not much really. Let’s look at
figure 5. I compare the growth rate in the euro area before and after 1999. I also
compare it with growth rates in other industrialized countries before and after 1999.
The impression we get is that there is very little evidence that the euro has boosted
growth as was promised. On the other hand there is also no evidence that it hascontributed to a lower growth performance. This is in a way is very comforting
because it confirms that in the long run money and monetary institutions do notmatter for real things such as economic growth.
Figure 5: Average real growth of GDP in a number of countries

Source: Bruegel, Coming of Age, Report on the Euro Area

9

It is also surprising to find that there is very little evidence of a superior growth
performance of US versus Eurozone. Yet the perception today is still very strong that
US has performed better, and that this is due to greater flexibility of markets in the
US. This is now repeated so often that it has become an act of faith. Yet the evidence
is very flimsy. In order to illustrate this, I compare an index of market rigidities withproductivity growth performances of OECD countries.
The OECD has constructed an index of product market regulation. I will use this here
as our index of market rigidities. This index synthesizes different indicators of
product market regulations (e.g. price regulations, barriers to entry, protectionist
measures, etc.). I show the index computed for the year 2003 together with theaverage productivity growth during 2001-06 in figure 6. On the horizontal axis theindex of product market regulation (PMR-index) is shown. The higher the index themore regulated are the product markets of the country in question. On the vertical axis
I present the average growth rate of labour productivity during 2001-06.
The most striking feature of this figure is that the index of product market regulations
does not seem to have any power in predicting the wide divergence in productivity
growth developments.

In fact it seems to predict the sign wrongly. A simple

regression analysis reveals that the sign of the PMR-index is positive, predicting thatcountries with higher product market regulations have higher productivity growth (seetable 3). Since the coefficient is not statistically different from zero the correctconclusion at this stage is that the PMR-index has no significant effect on productivity
growth.
The previous analysis suffers from a potential bias due to the omission of animportant explanatory variable, i.e. the initial level of per capita GDP. Countries witha low level of economic development (low GDP-per capita) tend to have a lot of
product market regulations. They nevertheless grow fast because they are in the catchup phase of economic development. Thus the PMR-index correlates with the omitted
variable, GDP per capita. I therefore ran a regression adding the initial level of percapita GDP as an explanatory variable. The results are shown in table 3.

I observethat the PMR-index now has the correct sign but that it is not statistically significant.
In contrast, the initial level of per capita GDP (YCAP) has a strongly significant
effect. In addition, adding this variable to the regression equation dramatically

10

increases its overall explanatory power (the R2 is raised from 0.08 to 0.52). I obtain asimilar result when I use a dummy for transition economies instead if the initial per
capita income (see last column of table 3).
Figure 6
Growth of productivity (2001-06) and product market regulation (2003
EU and US
4,5
SK

PL

growth productivity (in %)

4
3,5
3
2,5

HU

CR

IR

GR

US

2
UK

S

FI

DK

1,5
1

A
B
NL

0,5

D

0,5

1

E
P
IT

L

0

F

1,5

2

2,5

3

product market regulation

Source: for the PMR-index: Conway, Janod and Nicoletti (2005) and for the
productivity growth:
http://ec.europa.eu/economy_finance/indicators/annual_macro_economic_database/ameco_a
pplet.htm

Table 3: Regression results: dependent variable productivity growth11

I conclude that the widely different levels of product market regulations acrosscountries have very little power in predicting the different productivity growthexperiences of the same countries 3.

5. Asymmetric shocks and divergencies in the Eurozone
One of the surprises of the functioning of the Eurozone has been the extent to which
the competitive positions of the Eurozone countries have diverged. I show the realeffective exchange rates in the Eurozone (based on unit labour costs) since 1998 infigure 5. The striking fact is the extent to which the relative unit labour costs havetended to diverge. As a result of these trends, some countries (Portugal, Netherlands,
Spain and Italy) have lost a significant amount of price and wage competitiveness.
Others, like Germany and Austria have gained a significant amount of price and wage
competitiveness 4.
There can be no doubt that part of these divergent developments in prices and wages
are the result of divergent national wage policies. Since 1999, Germany has followed
a tight policy of wage moderation. I show some evidence in figure 6. This presents
the yearly nominal wage increases in Germany and in the rest of the Eurozone(excluding Germany). I observe the strong decline of nominal wage increases inGermany. The rest of the Eurozone maintained more or less constant wage increases
around 3% per year. Thus, each year Germany tended to improve its competitive
position vis a vis the rest of the Eurozone. The contrast between Germany on the one
hand, and the UK and the US on the other, is even stronger. The latter allowed theirwages to increase by 4 or 5% per year.
This German policy of wage moderation has not been without consequences for theother Eurozone countries which have seen their competitive positions deteriorate
thanks to these German wage policies. Thus the latter have worked as “beggar-thyneighbor” policies forcing other countries in turn to also institute drastic policies of3

A similar result was obtained by Griffith, Harrison and Simpson (2006).
4

It could be argued that these trends may also be the result of different initial levels of percapita income so that they reflect a catch-up process (Balassa-Samuelson effect). Since thereal effective exchange rates shown here are based on unit labour costs they take into accountdifferences in productivity growth.

12

wage moderation 5. In this sense one can conclude that there has been a coordination
failure in the eurozone. There can be no doubt that this had led to a major asymmetricshock that will have to be corrected.
Figure 7 : Intra-euro area real effective exchange rates (based on ULC)

Source: European Commission
Figure 8
Nominal wage increases (in % )Germany

7Eurozone
US

6

UK

percent increase

5
4
3
2
1
0
2000

2001

2002

2003

2004

2005

2006

Source: European Commission, Statistical Annex to the European Economy

5

For a similar analysis in the context of the EMS, see Blanchard and Fitoussi(1992).

13

The correction mechanism is likely to be painful. Other countries will be forced tointensify their policies of wage moderation, inducing the former again to restrict wage
increases. All this is adding to deflationary tendencies characterized by low growth inconsumption and investment and by increasing unemployment.
The divergent movements of competitive positions within the Eurozone are not only
the result of German wage policies but also of the different speeds in the structuralreform process in the member countries. The process of structural reforms (labour
market reforms, liberalization of output markets) has remained a strictly national
affair. Some countries, e.g. the Netherlands and Spain have gone some way inderegulating employment protection systems, while other countries, e.g. France and
Italy have a long way to go. These divergent movements have much to do withdifferences in national political systems. They generate a potential for divergent
movements in employment and output (asymmetric shocks) within the Eurozone
which will necessitate adjustments in the future. As these are likely to be painful, they
are bound to lead to tensions in a monetary union.

6. The institutional weakness of the present Eurozone Governance: the Stability
Pact
The present institutional design of the Eurozone exhivit some weaknesses. Theseweaknesses manifest themselves both at the level of fiscal policies as at the level ofmonetary policies.
The Stability and Growth Pact (SGP) is seen as the cornerstone of the governance offiscal policies in the Eurozone. The proponents of this view see the SGP as thenecessary fiscal framework providing long run sustainability of national fiscal
policies. In so doing, the SGP makes a stability oriented monetary policy of the ECB
possible while at the same time providing sufficient flexibility for national budgetary
authorities to accommodate for asymmetric shocks.
The SGP, however, is built on a weak institutional foundation. The reason is thefollowing. As argued earlier, spending and taxation are still very much the
responsibility of national governments and parliaments. That is also the level at which
democratic legitimacy is vested. As a result, these spending and taxation decisions are14

backed by an elaborate process that is deeply embedded in national democratic
institutions.
The SGP now imposes top down an extensive control and sanctioning system on the
net effect (budget deficit) of this democratic decision making process by institutions
that are perceived to lack the same democratic legitimacy. Lawyers will undoubtedly
object that the SGP is the result of a Treaty that has been ratified by the same
democratic institutions, the national parliaments, so that it has the same legitimacy as
the national parliaments. This is undoubtedly true from a legal point of view. It is notfrom a political point of view.
When the Commission starts an excessive deficit procedure which aims at forcing
national governments to cut spending and/or increase taxes, it bears no politicalresponsibility for these decisions. In fact, the national governments do. When thesefollow up on the Commission’s procedure and cut spending and raise taxes they are
the ones who will be judged by their national electorates, and who face the threat ofbeing punished by the voters at home. In contrast, the European Commission at notime faces the prospect of being voted away. Thus from a political point of view, theEuropean Commission, which initiates the control and sanctioning procedure of the
SGP, lacks democratic legitimacy, because there is no mechanism to make theCommission accountable before an electorate for its actions.
This lack of accountability of the Commission makes the SGP unsustainable. Eachtime a conflict arises between the Commission and the national governments, theformer is bound to loose. This is also what has happened in November 2003 whenFrance and Germany disregarded the SGP. It will happen again when conflicts arise
between the Commission and the national governments. Thus, it can be concluded
that the SGP is a fragile institutional construction that is unlikely to lead to its
objective.
This problem will continue to exist as long as the nation-states maintain theirsovereignty over spending and taxation, and as long as those who decide about
spending and taxation are made accountable for decisions before a national electorate.
A similar institutional weakness exists at the level of monetary policies. The
Maastricht Treaty has defined the objectives of the ECB. The primary objective is15

price stability. The Treaty, however, adds that if price stability is not at risk, the ECB
should pursue other objectives, in particular, sustaining economic activity.
The ECB has filled out the fine print of its mandate by essentially dropping therequirement that it should pursue other objectives than price stability. It has done sousing the monetarist-real-business-cycle theory and claiming that by focusing on pricestability it automatically guarantees that the other objectives mandated in the Treaty
are fulfilled.
In addition, the ECB has given a practical content to the objective of price stability bydefining this as a rate of inflation below (but close to) 2%. Without asking permission,
the ECB has absolved itself from any responsibility about unemployment. It hasrelegated this responsibility to the national governments. It has done this using thewisdom of an academic theory, the empirical evidence for which is still being
debated. As a result the rest of society is not convinced and will not easily accept theattempt of the ECB to extricate itself from any responsibility about unemployment.
In addition, by relegating the responsibility of unemployment to the national
governments it creates a political problem that is similar to the problem identified
with the SGP. If national politicians have to bear the sole responsibility for
unemployment, it is only natural that they will want to use all available instruments tofight unemployment. The claim that all they have to do is to introduce “structuralreforms” (whatever that means) will not solve the problem because there is more to
unemployment than the structural component. The lack of instruments, both monetaryand budgetary, to fight the cyclical component of unemployment will lead national
politicians to the temptation to use these instruments because these politicians will bemade accountable before national electorates when they fail to lower unemployment.
One cannot maintain a political system where national politicians are made fully
responsible for unemployment while key instruments to deal with this problem havebeen taken away from them, and are held by those who do not want to be madeaccountable for this problem.
The conclusion is that either one gives those who are bearing the burden of politicalaccountability for unemployment the full panoply of economic instruments, or one
transfers at least part of the political accountability for this problem to European
institutions, including the ECB.

16

7. On the need for further political integration
In the preceding section I have argued that there is a problem of governance in theEurosystem. This problem of governance has two different dimensions. First,
important instruments of macroeconomic policy (monetary policy and the
management of the government debt and deficits) have been transferred to European
institutions. However, the political accountability for the results of the decisions takenin these fields is still vested with national governments. This creates a tension that isbound to be won by national governments.
Second, the fact that large areas of economic policies remain in the hand of national
governments create asymmetric shocks that undermine the sustainability of themonetary union. In particular, the use of uncoordinated national wage policies leads
to divergent trends in the competitive positions of the member countries of the
eurozone. This in turn leads to a vicious circle in which each country tries to recoverits competitive position by wage cuts, leading to deflationary spiral. Not only wage
policies have remained in the hands of national governments, the whole of social
policies together with the structural reform processes are national affairs. These create
a potential of structural divergences between member states leading to diverging
trends in output and employment.
These problems call for further steps towards political union. Without a politicalunion the Eurozone is at risk. The previous analysis allows us to describe how such apolitical union should look like.
A first element of such a political union is a certain degree of budgetary union, giving
some discretionary power to spend and to tax to a European executive, backed by afull democratic accountability of those who are given the authority to spend and totax. This will allow setting up an insurance system against asymmetric shocks in theEurozone. This can take many forms, and several proposals have already been made(see e.g. Mélitz and Vori(1993), Von Hagen and Hammond(1995)). The transfer ofbudgetary power does not have to be spectacular as was shown by the previous
authors. Nevertheless, it will require a European budget that increases significantly
relative to its present level of about 1% of GDP.
Second, an increased institutionalized coordination of a number of economic policy
instruments that have macroeconomic consequences will be necessary. I have17

mentioned social policies (including structural reform policies) and wage formation.
The need to coordinate does not imply that these areas should be fully centralized.
Rather it means that spillover effects of decisions in these areas into the monetary
union should be internalized. Thus, decisions like cutting the working week in France
which have obvious implications for the Eurozone as a whole should be a matter ofcommon concern, and should not be allowed to be decided by individual countries
without consultation with other countries. Similarly, national wage policies will haveto be coordinated in order to avoid asymmetric developments in competitive positionsof the member countries.
Third, accountability of the European institutions that today take major decisions at
the macroeconomic level will have to be improved significantly. This includes the
ECB, an institution that singularly has managed to escape any serious degree ofaccountability. Improving accountability of the ECB also implies that the definition of
the objectives of monetary policy should not be left to the sole judgment of the ECB,
as it is today. The definition of the objectives of the central bank belongs to thepolitical sphere. It is not just a technical problem that the ECB alone decides about. It
also follows that the independence of the ECB should be restricted to instrument
independence, much in the same way as this is done today in major countries in theworld, such as the UK, the US and other industrialized countries. This means thatonce the objectives have been defined by accountable politicians, the central bankshould be left free to pursue a policy that leads to these objectives.
In this connection a redefinition of the inflation target will be important. It appears
today that the inflation target pursued by the ECB is too tight. A target setting
inflation at maximum 2% per year makes it very difficult for countries that have lostcompetitiveness to restore it without great losses in terms of output and employment(see Sinn and Reuter(2001) on this). A target of 3% would make this equilibration
process easier. In a way it can be said that the present low target introduces rigidities
in the Eurosystem. Raising the target is equivalent to introducing greater flexibility,
which is the dream of central bankers.

18

8. An omitted “deep” variable
The German monetary union between West and East Germany that came about in1990 after a transition period of barely six months stands in great contrast with theEuropean monetary union. The German monetary union was part of a larger politicalunion. Thus, on July 1, 1990 the monetary union was established together with aunification of all important macroeconomic instruments (budgetary policies, transfer
system, wage bargaining, social security, regulatory environment). There can be no
doubt that such a comprehensive political union came about as a result of a strong
national sense of common purpose and an intense feeling of belonging to the samenation 6. In a way it can be said that this sense of common purpose was the deep
variable that made the monetary and political union possible in Germany. Put
differently, monetary and political union were endogenous variables that were driven
by a common force. The existence of this deep variable made it inconceivable that
Germany would have started with a monetary union without having a centralized
budget capable of making large transfers between regions, or without a unified social
security system.
This deep variable is absent at the European level. It is this absence that makes the
progress towards political union so difficult in Europe. The lack of a deep variable
also explains why Europe started with monetary union. The latter can be considered tobe the easy part on the road to political union. But at the same time it puts the wholeprocess at risk. Without a sense of common purpose it is very doubtful that further
progress towards political union will be made. And as I have argued, without thesesteps towards political union the monetary union will remain a fragile construction.

9. Conclusion
In this paper I have surveyed the achievements of the Eurozone together with thechallenges to which is has led. Rather than summarize this survey, I want to draw the
key conclusions relating to the link between monetary and political union.
I have argued in this lecture that the long run success of the Eurozone depends on thecontinuing process of political unification. Such a political unification is needed to6

See Baldwin and Wyplosz(2006) on this issue.

19reduce the scope for the emergence of asymmetric shocks and to embed the Eurozone
in a wider system of strong political ties that are needed to take care of the inevitabledivergent economic movements within the Eurozone. In addition, such a politicalunion is necessary to deal with the flaws in the governance of the Eurozone. The
major flaw is that while national politicians continue to bear the full politicalresponsibility for unfavourable trends in unemployment, key instruments to deal withthis problem have been taken away from them and have been transferred to European
institutions that bear no political responsibility for their decisions.
The recent no votes concerning the European constitution signal that there is a strong“integration fatigue” in the European Union today, making it unlikely that significant
progress in political unification can be made. This will continue to make the Eurozone
a fragile regime. In the long run, however, there can be little doubt: without further
steps towards political union the Eurozone has little chance of survival.

20

References

Alesina, A., Angeloni, I., and Etro, F., (2001), The Political Economy of Unions,
NBER Working Papers, Cambridge, MA.
Baldwin, R., and Wyplosz, C., The Economics of European Integration, 2nd Edition,
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